Using Cap Rate To Value Apartment Deals

Cap RateWhen looking at apartment deals to buy one of the most basic things you need to achieve is an understanding of what the property you are looking at is worth. If you are buying through commercial brokers, you’ll have the list price, and then there will be all kinds of ratios and measurements they throw at you to supposedly help you analyze the investment.

Any given ‘offering memorandum’ will contain Gross Rent Multiplier (GRM), Cash-On-Cash Return (COC), Internal Rate Of Return (IRR), Capitalization Rate (Cap Rate), and even more if they are really zealous.

If you are buying direct from the Seller you are confined to what you know about valuing apartment buildings, and what the Seller tries to convince you the property is worth in order for you to feel justified in paying the price he/she wants.

It’s helpful to be able to cut through waffle and get to the point, because apartment buildings are income property, and income is measured in numbers, making the analysis of them very concrete. Out of all the ratios a person throws at you to value a property, the only one that is really of any use to use is the Cap Rate, which stands for Capitalization Rate.

You calculate the Cap Rate for an apartment building by taking the Net Operating Income (NOI) and dividing it by the value of the property.

NOI / Value = Cap Rate

So if you have an apartment building that is being marketed at $7,950,000, and the actual NOI is being presented as being $650,000, the Cap rate the Seller is telling you the property generates is as follows:

$650,000 / $7,950,000 =  0.0818 x 100 = 8.18%

What this 8.18% is actually tells you is that if you had $7,950,000 of investment capital and you used it to buy this property, all cash, after twelve months had gone by and you received $650,000 of Net Operating Income, your return on investment from income in the first year of ownership would be 8.18%. If the price is decreased, or the NOI increased, the Cap rate goes up. If the price is increased or the NOI decreased, the Cap rate goes down.

How Is Cap Rate Used?

1. To Value Income Property: Due to the Cap rate being the quotient of the Net Operating Income and the Value, it is used when you analyze a property for possible purchase. When you have the “market” Cap rate, the Cap rate that like properties (same property class, area, condition) are selling for at the current point in time, you can use that to calculate the current value of the property, based on actual rents being collected on and expenses being incurred by the property (This is a number that is essential for negotiating price with the Seller). And you can calculate the future retail value of the property; the value of the property after all repairs have been made and it has been fully leased up and stabilized. With these two values you will now see the spread in the deal and know your buy and sell target values.

2. To Gauge The Risk Of Owning A Certain Property: Let’s say you are a buyer in Los Angeles and you have two properties you are looking at, each one producing a Net Operating Income of $500,000 per year. One is in Westwood,  near UCLA, the other is Van Nuys, near the old GM auto plant. After taking all factors into consideration you are willing to buy the Westwood property at a 4% Cap rate, and the Van Nuys property at a 7% Cap rate.

Westwood Property:    $500,000 / 0.04 = $12,500,000

Van Nuys Property:     $500,000 / 0.07 = $7,142,857

Both properties produce the same Net Operating Income, but you are going to shell out $5,357,143 more for the property in Westwood. Why?

Well, you can pay more for the property in Westwood because there is a lower risk of you losing your money than if you bought the property in Van Nuys.

In Westwood, you have low crime, high end shops, and Bel Air just to the North. The property is a Class A property with all the latest technology, features and services that attract the highest quality tenants. You can charge high rents and extract a sizable security deposit. Due to the high desirability of the property and the area, vacancy is low, management light, and due to the high land value the property will appreciate handily when the economy heats up.

In Van Nuys, the crime rate is higher, the neighborhoods are less well kept, the shops appeal to lower incomes, there are many high traffic thoroughfares. The area is not as desirable to live in, and feels less secure. The property is a Class C building with technology and systems that haven’t been upgraded in about thirty years. Tenant turnover is moderate and management is always working hard to keep vacancies as low as possible, and maintenance taken care of. While property management remains disciplined there is high cashflow, thanks to the lower land value and monthly costs compared to rents, though if management slacks off and vacancies increase the value of the property deteriorates rapidly.

In markets in general there is higher demand for lower risk and greater certainty of return, and the high demand for the low risk associated with buying the Westwood property is reflected in a low Cap rate. Conversely, there are fewer real estate investors in general who are interested in applying the active management the Van Nuys property would require to be profitable, and the lower demand for the high risk associated with the Van Nuys property is reflected in a high Cap rate.

3. To Understand The Demand For A Certain Class Of Property At A Certain Time: For each different Property Class, the Cap rate reflects the current state of demand, even for an individual property. For any set of like properties there are a certain number of them available (the supply), and there are the buyers active in the market interested in buying them (demand). The Cap rate that is revealed from the buying activity reveals the state of demand for property in this category at this point in time.

If you are familiar with a property, or set of like properties n a certain market, tracking their Cap rate(s) over time will reveal the current state of demand of the property(ies) at this point in time. The property in Westwood, for example, in 2007 would have had a Cap rate of 1%, or even a negative Cap rate, as the land appreciates out of sight. Four years later though, in 2011, it is on the market at a 5% Cap rate. (Ouch! Someone took a $40M loss!)

This can be applied for an individual property, or for an entire Property Class across a particular market.